Depreciation is an accounting method that allows businesses to gradually write off the cost of big-ticket items over the life of the item. "It is an annual allowance for the wear and tear, deterioration or obsolescence of the property," according to the IRS. In this way, the company's bottom line isn't adversely impacted from the entire cost of the item being absorbed by the company at one time. This also more accurately reflects how big-ticket items are paid for: Companies generally pay for them over an extended period of time rather than all at once, depending on how expensive the item is.
What Can Be Depreciated
You can depreciate just about any type of tangible property except land. Even certain types of intangible property, such as patents, copyrights and software, can be depreciated because they have a known or estimated useful life. Though depreciated property needs to be owned by the company taking the depreciation, if the company makes capital improvements to leased property, those improvements can be depreciated.
What Is Straight-Line Depreciation?
Though multiple methods of calculating depreciation exist, straight-line depreciation is the easiest method to calculate and use. You simply take the cost of the property and subtract any value it will have at the end of its useful life. For instance, a car costs $20,000 and will be worth $4,000 at the end of its life cycle. The result is $16,000 ($20,000 minus $4,000). The length of the useful life is the other part you need to know. For a car, you might estimate four years of useful life. Divide the result you got above by the useful life figure, and you get the annual depreciation amount ($16,000/4 equals $4,000). This is the amount you write off each year.
When Does Depreciation Begin and End?
The property begins depreciating when it's placed in service for a business or organization. The depreciation deductions end when the amount of the purchase price less the final value is deducted. At this point, the property will have reached the end of its useful life.
Modified Straight-Line Depreciation
The IRS recognizes another type of straight-line depreciation called the alternative MACRS method, or the modified straight-line method. The actual calculation of the deduction is the same, but the alternative MACRS allows you to choose an alternate useful life over which to recover the costs of the property. Choose the shorter time span and you can take larger annual deductions but for a shorter time; choose the longer time span and the opposite happens.
The advantage of using the straight-line depreciation method, besides its simplicity, is that you have a fixed and known deduction. This provides the company with an equal, annual deduction over the life of the property. This means that the bottom line of the company won't look better or worse from year to year because of changes in your depreciation deduction.
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